Driving Off the Fiscal Cliff

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Driving Off the Fiscal Cliff into Taxmageddon

Thoughts on Being a Source of Continuing Revenue


Baidu ( BIDU ), The Sleeping Giant

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Lots of nasty financial events from the past have catchy nicknames, including the Asian Contagion and the Shanghai Surprise, Black Friday, the Great Recession. It's always interesting when an approaching catastrophe gets its own nickname. I'm thinking of "The Tech Bubble" and "The Housing Bubble," both of which anticipated the bursting thereof, and "Y2K," which looked forward to a collapse of the world's information infrastructure when computers couldn't find a date in their date counters that maxed out at 1999 and didn't have any way to enter all four digits of 2000.

Right now, the apocalypse generating the catchy names is the approach of the Congressionally mandated budget moves called Taxmageddon or The Fiscal Cliff.

The Fiscal Cliff consists a package of tax increases (allowing the Bush tax cuts to expire) and spending cuts that will go into effect in 2013 unless Congress can find a way to agree on a saner policy. Estimates are that these tax increases and spending cuts would slice about 4% off the U.S. gross domestic product ( GDP ), which would wipe out all growth and kick the U.S. back into a recession.

The conflict at the core of the Taxmageddon scenario is that Democrats want to reduce the Federal deficit by raising taxes on the rich, while Republicans want to cut spending. That's a little oversimplified, but basically accurate.

The two parties are now locked in what has the potential to be an interesting policy debate about the economic future of the United States. Unfortunately, it's also a year when we will elect a president, a new U.S. House of Representatives and about a third of the U.S. Senate. 

Accordingly, following U.S. traditions surrounding election years, our leaders seem more interested in mouthing platitudes, demonstrating their ideological orthodoxy and scoring debating points than they are in actually solving the deficit problem. The whole Taxmageddon phenomenon is a giant game of chicken, with the participants apparently quite willing to let the U.S. go over the Fiscal Cliff as long as they can blame the results on their opponents. And if they can't get their opponents to blink, they can at least try to defend themselves from the attacks of their constituents by citing the (artificial) crisis. 

Right now, the stock market is more worried about the possible fallout from the crisis in Europe than it is about the Federal deficit. But that will change soon, especially when we get the election over with and the newly inaugurated president and leaders of Congress actually have to come to grips with the debate.

Everyone is likely to be disappointed with the result of the debate, when it finally happens, and that's because extreme ideological positions are not useful tools for running a country, just for winning elections.

As always, we at Cabot will manage our growth portfolios with our usual total disregard for the political campaigns, rhetorical firestorms and predictions of disaster. The only thing we care about is what the markets are doing, and we can tell that by looking at our charts. So neither Taxmageddon nor the Fiscal Cliff will figure in our stock picks or our buy and sell recommendations. 

If that kind of benign indifference to politics sounds like a good proposition to you, you can always find a Cabot newsletter that will fit your investing goals here.

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I admire King Gillette for being the innovator behind the "sell the razor cheap, then sell them razor blades until the end of time" idea, but I think disposable blades are too expensive. Still, because I've actually been shaved with a straight razor and experienced the excitement of having a stranger wielding a surgically sharp knife an inch from my carotid artery, I'll take the multi-blade, pivoting razor cartridges with their little pads of aloe every time.

But that doesn't mean I have to like being some company's cash cow. In fact, I'm getting tired of being a source of continuing revenue!

Despite my personal feelings, a perpetual revenue stream is the ideal for lots of great companies. Intuitive Surgical ( ISRG ), the maker of the revolutionary da Vinci surgical robot, sell its machines for between $1 million and $2.3 million each, then supplies all the necessary replaceable parts and single-use devices for between $100,000 and $170,000 per year. That certainly puts the cost of shaving cartridges in perspective. But you can't really object to paying for quality parts and disposables when a doctor is snipping around your heart (or, even more critically, your prostate) with scarily sharp robotic scalpels.

Likewise, Green Mountain Coffee Roasters ( GMCR ), despite the stock's recent massive correction, can expect a long run of selling K-cup single-serving coffee pods to a lot of people who bought its heavily discounted Keurig brewing machines.

Some recurring expenses are just fine. I don't begrudge my pickup truck its maintenance money for oil changes, tune-ups and tires. And I'm perfectly happy to feed the devices that demand new batteries. But those things are just the disposables necessary to keep my wheels rolling and my flashlight bright. 

But now, in my house, there are a humidifier, a bathtub, a refrigerator, an electric toothbrush, a vacuum cleaner, a microwave, a lawnmower, a microfiber duster, a mop, a mosquito repeller and a number of other appliances and tools all with follow-on purchases built right into their design. And, in contrast to the old broadcast televisions that delivered programs to everyone for free, there's a Comcast subscription that brings television and Internet into my home for only hundreds of dollars per month.

Mind you, I'm not ready to give up any of these goods and services that nibble away at my money like mice. Lots of them actually deliver improved performance in exchange for tolerable investments in disposables. But they all add up, and I'm getting tired of it.

I'd be glad to hear from you on the topic. Let me know what you think.

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My stock pick today is an old friend that has fallen on hard times, at least as far as its stock price goes. The company is Baidu ( BIDU ) , the dominant Internet search engine in China. Roy Ward, the editor of Cabot Ben Graham Value Report, our value investing newsletter, recently sent me a memo making the value case for BIDU.

Roy pointed out that, although BIDU's P/E ratio is a relatively high 24 times estimated earnings, its price-to-earnings-growth ratio (PEG ratio) is an attractive 0.70 based on 35% expected EPS growth during the next five years. 

While it's always comforting for a growth investor to get a concurring opinion from a value guy, I have two independent reasons for liking BIDU.

First, the revenue and earnings growth history for Baidu is ridiculously strong. Baidu's revenue growth slowed to 40% in 2009, but rebounded to 81% in 2010 and climbed to 92% in 2011. In those same three years, earnings grew from 66 cents per share to $1.55 per share to $3.03 per share. Estimates for 2012 are for $4.58 per share. The company has eight straight quarters with after-tax profit margins above 40%.

The knock on BIDU right now is that Chinese search activity is migrating to mobile devices at an increasing rate, giving competitors without a big online infrastructure a way to compete in a new arena. That fear, plus the general concern about slowing Chinese economic growth, has pulled BIDU from its most-recent high of 154 to below 110, a dip of almost 30%. 

I'm waiting to see what BIDU will do when the Chinese government, taking advantage of its benign inflation statistics, decides to use its treasury for a little economic stimulus. The current Chinese GDP growth rate of "only" 7% is a little lower than Beijing would like to see. Such a stimulus, plus the intriguing prospect of Baidu's new tie-up with Apple, would make BIDU an excellent choice for either a value investor or a growth investor with a slightly longer time horizon.

Sincerely,

Paul Goodwin  
Editor of Cabot China & Emerging Markets Report



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BIDU , GDP , GMCR , ISRG

Cabot Heritage Corporation

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